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Time to Give a Little

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Or give a lot is what I'm sure the bulls were feeling today, especially after the close when we received the earnings reports from Intel, IBM and Yahoo. After a down day and then down futures after hours, I'm sure the bulls are beginning to look around to see who else is going to hit them.

After gapping down today, the market was never able to get back up to close its gaps. By that measure, this was a bearish day. The selling was never really strong, although the down volume was twice the up volume, and the bounce into the afternoon looked like it might break some short term downtrends but they held into the close. Now we'll be facing another gap down tomorrow based on after-hours futures reaction to earning news. Two back-to-back gap downs will not look pretty. But tomorrow could be full of surprises, just as most days are. I've seen time and again the after-market futures react one way to INTC earnings and then the market goes completely in the opposite direction the following day.

The continued drum beat of bad news out of Iran and its refusal to bow to international pressure is worrying the market. Most everyone knows the US doesn't have the spare military capacity to invade Iran so few are worried about that. It will take forever and a day for the U.N. to decide to do anything so it's not as if the market is worried about something happening in the next week. But it's the uncertainty that the market never likes and when investors get nervous they sell, they don't buy. Therefore today's decline looked more like a lack of interest in buying rather than hard selling. We'll have to wait to see how the earnings reports might change that mindset.

Also worrying the market is the news out of Nigeria where oil platforms and other oil pumping stations are being threatened. Shell confirmed today that it has shut in 115K barrels of oil per day on some of its offshore drilling platforms. They've evacuated many of their personnel until things settle down. All of this (Iran and Nigeria, not to mention what's going on in Central and South American countries and their threats to nationalize oil drilling and pumping stations) has created a lot of fear in the oil market. Hence oil's nearly +4.5% rise to just under $67 this afternoon. That's going to put the fear of inflation and slower economic growth back on the table of concerns. Again, uncertainty and the market hates that.

Throw in some profit taking after a very strong run-up from January 3rd and it's no surprise to see the market pull back. The longer term question of course is whether or not the current pullback is just that--a correction to the January rally--or instead is the start of something more serious to the downside. It's too early to tell so we'll just have to take one leg at a time and hopefully get some good signals soon. In the meantime it's certainly a good time for those who are long the market to cinch up those stops and protect profitable positions.

The economic reports were relatively minor today, and all the reports this week will likely be overshadowed by earnings. But we received the NY Empire State index which dropped to 20.1 vs. the revised 26.3 in December. This was slightly less than expectations of 21.0. The prices paid index came in virtually even at 46.6 vs. 46.7 in December while prices received increased from 17.8 to 27.4. The new orders index was the same as December's at 27.2 and shipments increased to 32.0 from 18.7 in December. The employment index was stronger at 11.3 vs. 5.0 for December. Inventories fell to -12.3 from -4.4 in December.

These numbers are of interest to investors because it provides a heads up as to what the ISM will look like and opinions seemed to agree that we can probably expect a good number in January (it had fallen to 54.2% in December from November's 58.1%). Any number above 50 indicates expansion instead of contraction and no surprises in ISM is expected.

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Capacity utilization numbers came out and showed continued growth in this area by rising +0.6% to 80.7%, a 5-year high (October 2000). That's a good news/bad news number since higher capacity utilization may become a concern to the Fed as they weigh their decision about future rate hikes. An increase in capacity utilization threatens inflation as demand increases and the ability to produce more products decreases. Bottlenecks in the supply chain typically begin to show up once capacity utilization reaches about 81%, according to Rick MacDonald, head of research at Action Economics. Interestingly, MacDonald mentioned the fact that "though the market expects the economy to slow in 2006, it is noteworthy that growth is entering the new year with its most solid trajectory since the late-1990s." I say this is interesting because we all know what happened to the market after the late 1990s. We might be setting up for a similar outcome.

Industrial production rose in December +0.6% vs. +0.5% expected. For all of 2005 industrial production rose +3.2%. For December, manufacturing output rose +0.2% which included high tech production which was up +2.7%, motor vehicle production was down -2.8% and mining output was up +2.5%. Semiconductor output was up nearly 31% in 2005. But excluding high-tech goods, much of the factory output for December was flat. Manufacturing output for the 4th quarter was up +7.9%, much of which was attributed to a post-Katrina rebound.

The bidding war between Johnson & Johnson (JNJ 61.25 -0.54) and Boston Scientific (BSX 23.84 -1.30) to purchase Guidant (GDT 76.21 +5.38) continued today with BSX raising its offer to about $27B or $80/share. Guidant has accepted JNJ's offer for $71/share but GDT's Board declared BSX's offer as superior to JNJ's which makes GDT's offer good until Jan 25th.

But all of these things today were just noise to a market that is clearly feeling the jitters. Whether it's because the rally from Jan 3rd was too much too fast or because of what's happening in Iran and Nigeria, or because the earnings season has started off on the wrong foot, it looks like profit taking is the name of the game. Let's see what this has done to the charts.

DOW chart, Daily

The DOW appears as though it's going to head back down towards its long term downtrend line from January 2000 through March 2005, currently near 10850. Note the 50-dma (blue) rapidly rising to try to catch the DOW's fall. Neo's coming to save Trinity. The current pullback hasn't done anything yet that declares the rally dead but it is raising some serious questions about it. It's possible from an EW perspective to call the rally complete at the last high. Unfortunately it takes a drop below its Jan 3rd low of 10684 to confirm that a longer term top is in. In the meantime I'm waiting for a stronger bounce to determine its shape (to see if it's a correction against the decline or a more impulsive trend reversal back to the upside). A 50% retracement of the January rally is at 10866 and a 62% retracement is at 10823. Watch either level for potential support. If we've got higher to go, which I'm not yet discounting, this pullback is "designed" to shake out the weak longs and suck in the bears. Too early to tell.

SPX chart, Daily

SPX looks a little stronger than the DOW in that it hasn't even retraced 38% (1276) of its January rally yet. A 50% retracement is at 1270 and could be the target if we get a healthy drop on Wednesday. SPX stopped this afternoon at a trend line along the highs since August 2005, which is also where its 10-dma is located (near 1282). Both of these could be blown away Wednesday morning if the cash market follows through on the after-market futures action but I've seen enough of these negative futures reactions in the afternoon get completely reversed by the time the cash market opens that I'm not discounting that possibility Wednesday morning. Wait and see is all I have to say. But if it does drop lower, watch 1270-1275 for support which is the area of the previous price congestion Jan 4-5.

Nasdaq chart, Daily

The SOX got beat up today and with it most of the tech stocks as well. Like SPX though, the COMP stopped at the trend line along the highs since August 2005, which is also where its 10-dma is located (2298). SPX and the COMP are very similar in this regard. The COMP has shown more relative strength during its 3-day pullback, not yet coming close to its 38% retracement of the January rally at 2278. If that level gives way the next Fib support is 50% retracement at 2261. Its 20-dma is currently just above that at 2264.

SOX index, Daily chart

Again, similar to SPX and the COMP, the SOX stopped at its trend line along the highs from August 2005 and its 10-dma at 517.72. With INTC and IBM getting their fannies whooped after hours, the SOX looks primed for a steep drop Wednesday morning but as I mentioned above, the cash market has an interesting way of reversing negative after-market action in the futures so we'll just have to wait and see. Fib support is at 38% retracement of the January rally at 514.61 and 50% at 507.06. An even steeper correction could take it down to 62% at 499.52 which is close to its 20-dma at 502.

BKX banking index, Daily chart

The pattern in the banks continues to stump me a little. Resistance at the top of a large parallel channel in place since January 2004 continues to hold price back and yet price refuses to drop hard. Today price was supported by its 50-dma at 104.24. I'm getting the impression from this one that it may try for another run to a new high but the flag pattern (an ascending wedge) calls this an ending pattern from it November 2005 high. It calls for one more run back up to a minor new high and if it does that it should be loaded with all kinds of negative divergences. The banks got hit with disappointing earnings reports from a couple of banks but they held their 50-dma. I don't feel particularly bearish about this index yet and that has me suspicious about the drop in the broader market.

U.S. Home Construction Index chart, DJUSHB, Daily

I thought the home builders might be able to make it up to resistance in the 1050-1060 area but it reached just shy of 1040. It could still try for higher but it needs to do so before dropping below 979 otherwise it would violate a potentially bullish EW count from its December low. If it can hold here it might be able to make another run higher, otherwise a drop below 979 would suggest we've seen the high in the home builders.

Oil chart, February contract, Daily

Blame oil for today's pullback. Everyone else is. Rather than blame oil I think both oil and equities are simply reacting the same news about Iran and Nigeria. Uncertainty in these countries is causing traders to worry about the supply of oil and the potential negative impact to economic growth. Oil's charts are overbought on all time frames and showing negative divergences at new highs. This is begging for a pullback but with the February contract due to expire this week we could be seeing short covering as traders exit positions. I continue to believe oil is set up for a big fall but obviously news is trumping technicals right now.

Oil Index chart, Daily

The oil stocks liked the spike in oil price and ran up to tag a Fib target at 575 which is also at the top of a parallel up-channel for price action since the October low. This too looks ready to roll back over and the fact that both oil and the index look in synch here could mean we're at or very near a high for both.

Transportation Index chart, TRAN, Daily

While oils stocks liked high oil prices, the Trannies hated them. Airlines alone, down just over 6% today, hurt this index. There's no question that this chart now looks very bearish. I had been thinking the past couple of days that the Transports had a slim chance of making a run to a new high but now that's looking rather doubtful. And if they start to drop hard, that raises questions about the broader market. If the DOW were to roll back over and take out the Jan 3rd low, you can bet everyone and their brother would be talking about the non-confirmation between the DOW and the TRAN and bearish that it. And they'd be right. The TRAN was not able to hold onto its 50-dma today and if closes 3 days below this important moving average, it would then become strong resistance. It's getting critical here.

Before looking at the US dollar and gold charts I wanted to discuss what the Fed is up to. I've discussed in previous reports the Fed's actions in regards to the amount of money they've been pumping into the monetary system (as measured by M-3). Recent numbers show it's not only continuing, but in fact is accelerating. M-3 rose during the week of January 9th by $25.8B, a 13.1% rate of growth, which is obviously well in excess of our GDP growth rate or CPI (and certainly more than PPI). M-3 is up more than $82B in the past two weeks, over $118B in three weeks, $145B in the past month. This is a rate well in excess of $1 trillion per year. At this rate we should expect a devaluation of the US dollar and one wonders why the Fed would do that. And to think that they will no longer be reporting M-3 after March, one wonders what they're really up to. It's a little convoluted but bear with me while I try to bring this around to what the Fed appears to be doing, and why our equity and bond markets are being supported in the process (and why it's dangerous for bears).

There was a recent article by Harvard University economists, R. Hausmann and F. Sturzenegger where they argued that we don't currently have global current account imbalances (this is basically the measure of what we owe to others vs. what they owe us). They note that between 1980 and 2004, the US ran an accumulated current-account deficit of $4.5 trillion. That high of a deficit suggests the US should be paying out much more on its liabilities than it receives in income on its foreign-owned assets. But the US net income position remained in surplus in 2004 at $30B, the same as its surplus in 1980. Three factors have helped support the US's net income position. First, the US has generated a higher rate of return on its assets than it pays on its debt (US assets are predominantly in equities, while its liabilities are principally in bonds). Second, the bull market in bonds has held down interest rates, cutting US debt servicing costs. Third, the dollar's fall between 2002 and 2004 boosted the net income balance by paying our debts in cheaper dollars.

Even if the US maintains high rates of returns on its foreign assets, with a current-account deficit approaching an annual rate of $800B this will add to the amount of external debt and lead to higher interest payments. If US interest rates continue to rise (the Fed doesn't appear to be done), it will result in higher interest payments on the shorter-dated securities the Fed uses. Even if the trade deficit stabilizes (unlikely), the current-account deficit and external debt are on an explosive upward path. Ultimately, US domestic demand has to slow and the dollar needs to fall. This last sentence is important to remember--in order to stem the increase in the current-account deficit the domestic demand must slow and the dollar needs to fall.

The dollar's decline since 2002 had begun to make US companies more competitive, but the rally in the US dollar during 2005 threatens to reverse this. The current level of the dollar implies a further widening of the trade deficit. The fall of the dollar after 2002 and the reduction in US interest rates helped to boost the US's net-income position but this started to reverse since the rally in the dollar and increased interest rates in 2005. In 2005, the net income position was close to zero and in 2006 is likely to turn negative.

While the dollar was declining it was making overseas investments more valuable but 2005 reversed some of this. With the dollar now stronger compared with the end of 2004, this will increase the valuation of US assets thereby increasing the US's net overseas debt. When we put these three things together (increase in the dollar's value, increase in interest rates and increase in overseas asset valuations), we could see a sharp increase in the current account deficit. From a current account deficit that ran +/- 1% for most of the time between 1960-1980, it dipped to about -4% of GDP in 1987, back up to 0% in 1991 and has been dropping (becoming more negative) since. It's currently running close to -7% and is projected to be more than -10% of GDP in a few years. The primary method to stop this explosive decline in our current account deficit is a sharp drop in the value of the US dollar.

Now we come back to what the Fed is doing with M-3. It's possible the Fed is on the path towards deflating the value of the US dollar through hyperinflationary growth in the amount of money in the system. If the Fed knows they are nearing the point where they will have to begin buying back much of the US debt would it not be cheaper to do so with cheaper dollars? Could this be a reason they want to start hiding how much money they're creating? If they are going to set out on a path to purposely deflate the value of the dollar, they won't want to advertise that fact with a bullhorn.

If the Fed can double or triple the money supply, thereby reducing the value of its debt to half or one third the current value, think of the advantage to the US. And it's only because the US dollar is the world's reserve currency could we even attempt to get away with this. But how long do you think the US dollar would remain the world's currency once foreign central banks get wind of what's happening. They would surely attempt to deflate the value of their currency as well in an attempt to maintain parity with the US dollar.

In the meantime, with a lot more money being created by the Fed, there needs to be a way to get it into the monetary system. As I've mentioned before, the way it gets into the banking system is by the Fed buying stuff. It can be anything since once the Fed buys something, the money is then into the banking system. Their favorite technique is to give money to their banking dealers who typically buy securities--equities and treasuries. And this of course puts a false floor under the market--it's not real demand but instead is falsely created through the introduction of more money than the market knows what to do with it. It brings all new meaning to the phrase "don't fight the Fed". Only in this case it has nothing to do with interest rates and everything to do with the money they're creating.

In the meantime the US dollar should continue its bounce that started in early 2005. The EW pattern calls for one more leg up which could take it into early spring and get up to $95-96. Once the rally is finished, the longer term pattern calls for a steep drop that will last several years and ties in with the above scenario. Note too that the strong rally in gold may be due to sniffing out the hyperinflationary growth in the US dollar. We live in strange times and the market is no longer a free market.

U.S. Dollar chart, Daily

The US dollar continues to struggle just beneath its uptrend line from early 2005. There are several reasons why the dollar should find support between 88.36 (two equal legs down from its November high), 88.52 (200-dma) and 88.63 (62% retracement of the Sept-Nov rally). Once a floor is found I expect the dollar to continue its rally and the mid-90s makes for a good target. Once that is complete we should see a resumption of the bear market in the dollar.

Gold chart, February contract, Daily

Gold's rally to new highs now looks like the completion of the rally from August 2005. The new high shows a negative divergence against its previous high and this is what is expected for the 5th wave so I prefer the new EW count that I have on the chart. The short term pattern looks like the rally is complete or very close to completing--see 60-min chart below.

Gold chart, February contract, 60-min

The final leg up from the pullback to Dec 21st, what I have labeled as the 5th wave on the daily chart, looks to be forming an ascending wedge, a very common pattern for the 5th wave. Today's high may have been it for the rally although ideally I like to see a small throw-over above the top of the pattern and then a drop back inside. So if the uptrend line holds (about 552.70) and this rallies to a new high, watch it carefully for continued negative divergences and possibly a small throw-over. It should make for a good trade on the short side.

Results of today's economic reports and tomorrow's reports include the following:

Tomorrow we get CPI data and crude inventories as potential market movers (though that's doubtful since the market is clearly more focused on earnings right now). Also the Fed's Beige Book at 2:00 might move the market as well.

Sector action was mostly red today, no surprise. As mentioned above, the airlines led to the downside, down just over 6%. Following the airlines down were the SOX, networkers, Trannies, cyclicals and retail. The few green sectors today were primarily the energy indices and the gold and silver index broke even (but closed near its low for the day so that could be another heads up that gold may have topped today).

Not helping the airlines today was Continental Airlines (CAL 17.21 -2.23), down about 11%. This followed the company's 4th quarter loss and a forecast of more losses in the 1st quarter 2006. CAL is down sharply from its 22.27 high on Jan 9th. US Airways Group (LLC 30.00 -4.08) also got taken out to the woodshed today, getting a 12% haircut. It's down from its high of 40.60 on Jan 4th.

Analyst downgrades on Advanced Micro Devices (AMD 32.86 -1.27) and Applied Materials (AMAT 19.76 -0.39) put some negative pressure on the semis today and the negative reaction to INTC and IBM could continue to hurt the SOX tomorrow.

Earnings disappointments are mounting--Alcoa and Dupont started it off on the wrong foot last week with disappointing earnings. By the way, did you hear that Alcoa has announced that it will no longer provide defined benefit pension plans? This is the way most companies will fix their under-funded pension plans--they'll simply cancel them. And we wonder why corporations are getting a real black eye from much of the public. These kinds of actions are being done while corporate executives reward themselves richly and protect themselves with rich golden parachutes. I hold many of these executives in the same light as I hold our congressional leaders (that would be a black light, as in no respect for them whatsoever). There are exceptions of course but it's a shame what's become of our "leaders" and I use that term extremely loosely. I used to be a corporate executive so I'm allowed to blast them--what they are doing is criminal but there's little to do except as a share holder you can get a writing campaign started and get things changed.

The earnings disappointments continued this morning with Fifth Third Bankcorp (FITB) and Wells Fargo (WFC) reporting disappointing Q4 earnings. Now IBM, Intel and Yahoo have continued the trend by disappointing the market after hours with their earnings reports. This may set up a very negative tone for the market as we head into the thick of earnings season. One might thay they're already thick of earningth.

I came across a quote from an analyst with briefing.com who said "While there is no reason to suspect this quarter won't be like other quarters, with about two-thirds of the S&P 500 anticipated to [again] beat consensus estimates, the market always reflects caution ahead of the reports." If this is a common opinion, and I believe it is, the disappointing earnings could be a double-shock.

After the market closed we had three important earnings announcements which will likely (but not necessarily) set the tone for tomorrow morning.

Intel (INTC 25.53 -0.25) reported that their Q4 profit was up 16% but that their sales were down due to lower-than-expected shipments of desktop computer chips, and that its Q1 2006 sales forecast was also going to be below Wall Street's target, something the market hates to hear. They said the company earned $2.5B, or 40 cents a share, compared with $2.1B, or 33 cents a share, in the same period last year. Sales rose 6% to $10.2B but missed expectations of $10.56B. Expectations were for Intel to earn 43 cents a share, excluding stock option costs. INTC didn't say how much option costs had an impact on results. INTC fell more than 4% in after-hours trading, closing down -2.43 at 23.10..

IBM (83.02 -0.17) reported their Q4 results of $3.1B, or $1.99 a share, up +13% from $2.8B, or $1.67 a share a year ago. The per-share figures include stock-based compensation expenses. They reported a income from continuing operations of $3.22B, or $2.01 a share, which included 10 cents a share to account for pension plan charges. Analysts had expected IBM to earn $1.94 a share from continuing operations so a plus there for IBM. But revenue totaled $24.4B which was well below analysts' estimates of $25.4B. IBM's stock price jumped around after hours, above and below the 4:00 closing price, and then closed down -0.12 at 82.90, not nearly the shellacking that INTC got.

The last of the big three this afternoon was Yahoo (YHOO 40.10 +0.21) and they also got taken out to the woodshed after hours. YHOO reported net income of $247M, or 16 cents per share, compared to $187M, or 13 cents per share a year ago. Analysts had expected 17 cents per share and therefore YHOO missed by a penny. Perhaps they spent a penny where they shouldn't have. Revenue was $1.5B, up 39% from $1.078B a year ago. Revenue excluding traffic acquisition costs, or fees shared with partners, was $1.068B, roughly in line with analyst expectations and up 36 percent from $785M a year ago. But YHOO also disappointed in their forecast for a lower profit outlook. YHOO said it expects to earn between $410M and $440M in operating income in Q1 2006, short of the $475M expected by some analysts. Shares of Yahoo fell to $34.71 in after-hours, down 5.39 (-13%), erasing much of the gains the stock had made in the last 3 months.

One of the challenges facing companies, particularly tech companies, starting Jan 1, 2006, is the requirement to report stock option incentives as costs that will hit their bottom line. But analysts will not have to include them in their earnings forecasts. This will likely add to the confusion as the first quarter proceeds and we get company forecasts vs. analysts' forecasts. This will likely cause some additional volatility surrounding these earnings reports.

Tomorrow morning is set up for a large gap down if you look at equity futures after hours. DOW futures are down over 70 points from the 4:00 price. S&P futures are down 10 points (equivalent to 100 DOW points) and Nasdaq-100 futures are down nearly 25 points. This looks very negative and even more negative than I remember past INTC disappointments so be prepared for a big down day. But stranger things have happened in overnight futures. I've seen time and again where a strongly negative response to earnings from INTC gets reversed the following morning. Many times we see the market open up strongly down and then we get a strong rally. Manipulation? Perhaps. Or it could be the buying opportunity that larger funds wait for in order to snap up bargains. They are not afraid to step in and buy when the public is panicking.

So if you're short the market going into tomorrow, beware the v-bottom reversal. Don't be bashful about taking profits on an opening dip. You will likely have done well and don't be a pig. Remember, pigs get slaughtered. You may even want to take a small part of your profits and try the long side. Be careful either way since it will likely be emotional and volatile. Good luck, see you on the Monitor.

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